For the last 4 years oil prices had been fairly stable, moving between $100 and $125 a barrel. Since then oil has tumbled more than 50%, dipping under $50 a barrel for the first time since 2009. See the steep descent at the end? The price of oil has fallen so rapidly that many are wondering: just where is the bottom?

Source: tradingeconomics.com

World Oil Supply Outpacing Demand

The latest OPEC Monthly Oil Report shows that global oil supply continues to grow faster than demand. Not that world oil demand isn’t growing, it just can’t keep up with surging supply. Demand averaged 92.69 mb/d in the 4th quarter of 2014; while global oil supply averaged 93.16 mb/d in December 2014. That’s in millions of barrels per day, which makes a 470, 000 barrel difference!

Source: OPEC Monthly Oil Report, January 2015

A slight pullback in World supply from the peak in October of last year might mean that prices will stabilize, yet prices continue to remain depressed. So what’s going on?

For one, the U.S. continues to grow output, having increasing production in each and every quarter of 2014, but falling prices are expected to eventually curtail supply from the United States. When oil hits $45 a barrel, many oil rigs become unprofitable to operate. Output from North Dakota has already fallen, partly due to regulations, but the point remains: producers are acting to protect themselves from falling prices.

Additionally, OPEC estimates that global oil demand will be mostly flat in 2015 due to a sluggish global economy, suggesting that relief in the form of increased demand will not be coming any time soon. Producers will be left with no choice but to cut supply to affect prices.

So, that sounds pretty simple right? Producers cut back on supply, pocket their cash and go home to smoke cigars and drink martinis.

Except it’s not that simple…

Cut and Run, or Stay the Course?

Any producer who cuts back at this point risks losing market share, which means less money in their pocket in the future. If Saudi Arabia were to cut supply and demand suddenly recovered, the U.S. or another nation might be well placed to swoop in on their now-exposed turf.

Which is why OPEC members are reluctant, even agreeing in November to maintain their collective output target of 30 million barrels a day for the first half of 2015.

It’s a classic example of the Prisoner’s Dilemma game. In game theory, Prisoner’s Dilemma shows us why two or more actors might not cooperate even though it might be in their self-interest to. By cooperating to cut oil supply, all members of OPEC can benefit, but it takes just one sneaky OPEC member to renege on the agreement to turn it all on its head.

So now the strategy is to defend market share, letting producers that have the highest costs shut down as they lose profitability. The Arabian Kingdom is not actively pushing prices down, in fact they have kept production flat to slightly lower, but they are letting the market find a bottom and are willing to tolerate the hit to their bank accounts.

So what happens now?

Winners and Losers

Saudi Arabia can handle lower oil prices for a while. When prices were high the Kingdom saved – amassing nearly $900 billion in reserves.

On the surface Russia looks safe. Its break-even price places it in the middle of the pack alongside Saudi Arabia and with reserves of $420 billion the ex-Soviet nation should be fine, except that their currency is in the toilet.

When the oil price slide started the currency stood at about 35 roubles per U.S. dollar. Nowadays 1 U.S. dollar buys 65 roubles. The longer the currency stays devalued, the harder it becomes for the Russians to weather the storm.

The media is making the battle appear to be between the two biggest oil producers in the world: Saudi Arabia and the U.S.

The standard narrative is that surging U.S. oil production represents the greatest threat to Saudi market share and the Saudis are fighting back by letting the maxim of survival of the fittest run its course.

So far it doesn’t seem to be working.

A report from energy consultant Wood Mackenzie analyzed production data from over 2000 oil fields around the world to see how many could potentially go under due to low oil prices.

At $45 a barrel, which is where we’re at, only 400,000 barrels a day are unprofitable. That represents just 0.4% of global supply, and half of that comes from onshore U.S oil.
Many operators will also continue to operate even at a loss – preferring to increase inventory rather than shut down projects completely.

So far the idea that U.S. shale will be forced out of production is not borne out in the numbers. In the chart above you can see the production numbers for the 4 largest shale sites, all of which have increased. In fact, none of the seven regions analyzed by the EIA – accounting for 95% of domestic oil production growth – have decreased production.

What does the future look like?

It may be that low prices are here to stay – at least in the short term. Global growth in demand for oil is expected to be weak and no one wants to cut supply, lest they give up a piece of the pie. The most probable outcome is that we are entering a period of low prices that oil producers will just have to deal with, piling up their inventories until demand picks up again in the long run.

We will see oil companies hold off on expensive investment into new projects, as no one will want to spend the extra money. The hardest hit producers in the short-term are likely to be countries where nationalized oil provides the revenues used to finance large swathes of government spending.

In the long-term, expect to see prices pick up as demand rebounds. When that happens is an unknown but it is unlikely that the current situation represents some longer-term trend where oil is beginning to lose dominance to alternative energies – many of which are not viable enough to be robust substitutes.

Wall Street Survivor is on a mission to demystify investing through interactive and comprehensive education.

Online financial education is typically very dry and full of jargon. We believe online investing should be fun, challenging and potentially very lucrative. And we want you to share in that fun and excitement. So we don’t just teach investing and personal finance topics by telling you how. We get you doing right away, by competing in virtual stock trading games.